Will Congress Review Employee Stock Options?

Forman, Jon, THE JOURNAL RECORD

Large companies have long used stock options to attract and
retain key executives. A stock option gives an individual the right
to buy company stock at a fixed price for a stated period of time.
For example, assuming that Acme Co. stock is trading for $100 a
share, Acme might give its executive the right to buy up to 1,000
shares of Acme stock for $100 per share at any time in the next
three years. If the executive succeeds in pushing Acme's stock price
up to $150 a share, he can exercise his option and acquire 1,000
shares of Acme stock (now worth $150,000) for just $100,000. That's
a cool $50,000 of income for the executive and similar gains for
Acme's other shareholders.

Led by the high-tech sector, more and more companies are using
stock options to attract and motivate employees at all ranks.
Indeed, according to a recent study by the human resources
consulting firm of Towers Perrin, more than 11 million employees of
U.S. companies are now covered by some kind of stock-based incentive
plan, with stock options by far the most common type of incentive.

The taxation of stock options is governed by an unusually
complicated set of federal tax rules. These rules determine whether
an option will be taxed when it is granted to an employee, when the
option is exercised by the employee, or only when the employee sells
the stock itself. Special rules also determine the extent to which
any gain from the sale of the stock is eligible for the 20 percent
maximum tax rate on capital gains.

The federal tax code provides for two general types of employee
stock options: nonqualified stock options and qualified stock
options.

Nonqualified stock options are the most common. As with any stock
option, a nonqualified stock option gives the employee the right to
buy company stock at a fixed price for a stated period of time. In
general, under code section 83, an employee has ordinary income
whenever his employer gives him a valuable economic benefit as
compensation for services. Under this approach, an employee has
income equal to the fair market value of a nonqualified stock option
when that option is granted to him. And the employer deducts that
same amount as compensation for services paid to the employee (under
code section 162).

For example, if Acme gives its executive an unrestricted right to
buy up to 1,000 shares of Acme stock for $90 a share at a time when
the stock is trading for $100 a share, the executive should report
$10,000 in income (1,000 x [$100 - $90]), and Acme can deduct
$10,000 as compensation paid.

If the nonqualified stock option does not have a readily
ascertainable fair market value at the time of the grant however,
the employee does not have to report any income at the time of the
grant. Instead, when the option is exercised, the excess of the fair
market value of the stock acquired over the option price will be
included in the employee's gross income. And the employer will
deduct a like amount at that time.

For example, if Acme gives its executive the right to buy up to
1,000 shares of Acme stock for $100 a share when the stock is
trading for $100 a share, the executive typically will not report
any income at the grant of the option (and Acme will take no
deduction). Instead, assuming that the executive later exercises the
option when the Acme stock is trading for, say, $150 per share, the
executive will then include $50,000 in income (1,000 x [$150 -
$100]), and Acme will then deduct $50,000 as compensation paid.

Alternatively, an employer might want to provide its employees
with a qualified stock option. With qualified stock options, no
amount is includable in the gross income of the employee at the
grant of the option, or at its exercise. Instead, the employee waits
until he sells the underlying stock to pay any tax, and then all of
his gain will be taxed as a capital gain. …

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